Amazon’s move into groceries could squeeze Costco

Originally published June 19, 2017 at 1:57 pm
Updated August 1, 2017 at 1:27 pm

A cart full of organic produce at Costco in Issaquah last year. (Bettina Hansen/The Seattle Times)

Costco’s business model of membership fees, low prices, and high degree of vertical integration will help it defend against the e-commerce giant that’s now buying Whole Foods, but the competitive pressure will increase.

Costco’s shares have declined nearly 9 percent since news of Amazon’s deal broke. And at least two major Wall Street firms have downgraded Costco’s shares.

Deutsche Bank on Monday lowered its rating from “buy” to “hold,” saying “the pipeline of positive catalysts has played out and the competitive backdrop is intensifying” as both Amazon and Wal-Mart press their online and in-store efforts.

Amazon’s Whole Foods acquisition “represents a game changer with [Costco’s] competitive moat in grocery under greater threat while its digital platform lags peers, putting membership renewal at risk for decline,” a group of Deutsche Bank analysts led by Paul Trussell said in a research note.

The concerns echoed those of Goldman Sachs, which on Friday downgraded Costco from “buy” to “neutral,” saying Costco’s business model was “under pressure from multiple factors.”

“COST’s competitive edges have related to natural and organic and its membership model, which despite significant overlap with AMZN Prime offered an option focused on consumables not easily available via AMZN,” Goldman Sachs analysts led by Matthew Fassler wrote in a research note Friday. “AMZN is likely capable of offering superior pricing and delivery competency vs. incumbents.”

Fassler did say “we still believe COST and the warehouse club space offers unique value not accessible through other channels, and do not anticipate meaningful erosion in business trends any time soon.”

But, he noted, “we see a potential cap on valuation associated with AMZN’s ongoing expression of interest in consumables, combined with fading fundamental catalysts” such as sales increases associated with Costco’s switch from American Express to Citigroup and Visa. “Also, increased expansion by AMZN and online investment by WMT [Wal-Mart] create an imperative for COST to intensify its own investment in ecommerce.”

But at least one Wall Street firm believes Costco’s business model allows it to defend against Amazon, for now.

“$4.99 Rotisserie Chicken and a $1.50 hot dog meals are symbolic but indicative of a low price and high quality strategy which generates consistent global growth and price leadership in the industry,” Cowen and Company analysts led by Oliver Chen wrote in a research note Monday. “Our take is that simple competitive advantages form a defensive moat, for now, vs. AMZN Prime’s unstoppable rise.”

That business model includes membership fees that generate enough money for Costco to offer lower prices, and an unusually high degree of vertical integration — owning or having strong relationships with farms and manufacturing facilities. Such integration includes Costco working with farmers to help them buy land and equipment to grow organics, building its own poultry farm, owning and operating its own beef plant and hot dog factory, and having its own optical grinding factory.

Chen acknowledged that Costco needs to step up its online game, saying “the retailer needs to intensify its focus on e-comm to fortify its business for long-term success.”

Costco executives have acknowledged the company is a tortoise, not a hare, in the online arena, and that its focus is still on getting customers into its brick-and-mortar stores.

Cowen’s research indicates 64 percent of Costco members were also Amazon Prime members as of May, the investment firm said.

But Costco is unlikely to put in a competing bid for Whole Foods in order to slow the Amazon juggernaut.

“We think COST [Costco} will stick to its existing strategy and work on its own digital capabilities rather than seek to acquire WFM [Whole Foods Market] or other business,” Chen wrote. “Furthermore, we don’t believe WFM fits into its membership and warehouse business model which has ample expansion opportunity globally and into other services and business needs.”

For Amazon, “retailers with good customer focused brand equity, curation and superior brand portfolios, and depressed valuations could be takeover candidates such as JWN [Nordstrom] & URBN [Urban Outfitters],” according to Cowen.